Since 2003, prices of basic agricultural
commodities such as corn,
wheat, soybeans, and rice have skyrocketed
worldwide, threatening to
further impoverish hundreds of millions
of the world's poor.

Shifts in fundamental supply and demand
factors for food grains have undoubtedly
contributed to higher food
prices. Prominent among these shifts are
the increasing diversion of food crops for
biofuel production in the United States
and Europe; sustained drought and water
scarcity in Australia's wheat-growing regions;
flooding in the U.S. grain belt; rising
prices for oil and fertilizer worldwide;
and the adoption of European and American
meat-rich diets by the growing middle
classes throughout Asia.

On top of these recent developments,
long-term threats to worldwide agricultural
output have eroded the world food
system's resilience in the face of changing
supply and demand. Although decades in
the making, a loss of agricultural capacity
worldwide caused by soil depletion, climate
change, water scarcity, and urbanization
has begun to take its toll on food
production. Moreover, half a century of
import restrictions and cheap agricultural
exports by wealthy countries has devastated
domestic food production capacity
in poorer countries, forcing many countries
that were once self-sufficient to rely
on imported food from the world
market.

At the same time, however, the growing
presence of buy-and-hold investors in
commodity markets has prompted heated
debate among commodity traders, economists,
and politicians over other possible
causes of higher commodity prices apart
from supply and demand shifts.
Since 2001, the declining value of the
U.S. dollar, low U.S. interest rates, weak
stock market returns, and accelerating inflation have drawn investment dollars
away from stocks and into non-traditional
investments such as commodities.
This flight to perceived safety in commodity
markets turned into a stampede
in 2007 and early 2008, as a credit-induced
financial crisis in the United States
compounded these existing stresses on
global financial markets.

Rising commodity prices and financial
speculation on food are not new phenomena.
The 1970s saw a similar rise in commodity
prices in the United States, and in
the 1920s, U.S. investors formed commodity
pools to bet on commodity price
movements. But the quantity and liquidity
of money flowing through today's
global markets is unprecedented in human
history. The current commodities
boom could be a sign of looming agricultural
scarcity, or it may prove to be a
short-lived speculative bubble that will
deflate over the next few months or years.
But regardless of where agricultural commodity
prices are headed, the boom has
already begun to transform how food is
financed, grown, and sold, and may dramatically
change how people around the
world eat (or don't).

Commodity investment
goes retail

Commodity exchanges exist as a mechanism
for the producers and consumers of
grains, energy, and livestock to transfer
risk to financial institutions and other
traders. For example, wheat farmers
might seek to reduce the risk of price fluctuations
by selling a contract for the future
delivery of their wheat crop on a
commodity exchange. This futures contract
will guarantee a price for the farmer
selling the contract, enabling them to pay
for their planting costs, and avoid the risk
that the price of wheat may decrease between
the date they sell the contract and
the date they agree to deliver the wheat.
Food giants such as Kraft and Nabisco,
as well as smaller bakers and grain consumers,
typically purchase commodity
futures contracts to avoid the opposite
risk—that the price of their raw materials
may increase in the future. (Commodity
markets also trade "spot" contracts,
which entitle the purchaser to the immediate
delivery of a commodity.)

Because producers and consumers seek
to reduce risk, they function as so-called
hedgers in commodity markets. In contrast,
commercial trading firms and other
speculators bet on the price of a commodity
rising or falling, buying and selling
futures contracts frequently in order to
profit from short-term changes in their
prices.

Since 2001, commodity funds have
gained in popularity as a mechanism for
institutions and individuals to profit from
increases in commodity prices. These
funds purchase commodity futures contracts
in order to simulate ownership of a
commodity. By periodically rolling over
commodity futures contracts prior to
their maturity date and reinvesting the
proceeds in new contracts, the funds allow
investors to gain investment returns
equivalent to the change in price of a single
commodity, or an "index" of several
commodities (hence the name "index
investor").

Investors in these commodity index
funds include public pension funds, university
endowments, and even individual
investors, through mutual funds, for example.
Although these investors are similar
to traditional commodity speculators
in that both seek to profit from changes
in price, traditional speculators zero in on
short-term price shifts, while index investors
are almost exclusively long-term buyers
betting on higher commodity prices in
the future.

A Lexicon of Commodity Markets

Hedger—An individual or institution who buys or sells an asset to avoid
the risk that the price of the asset may change over time. In agricultural commodity
markets, hedgers are typically farmers and end-users of grains.

Speculator—An individual or institution who buys or sells an asset to
profit from fluctuations in its price, but takes on the risk of an unfavorable
change in the asset's price. In agricultural markets, speculators are typically
large financial institutions, but since 2003 a growing number of "index
investors" have speculated on the continued rise of commodity prices.

Futures—Tradable financial contracts used to buy or sell an asset at a
certain date in the future, at a specified price.

Spot Contract/Spot Market—A contract for the immediate delivery
of the commodity. Also called the "cash market" or "physical market," the
spot markets determine the current price of a commodity.

Over-the-Counter—Any contract or security traded outside of a regulated
exchange. Over-the-counter trading can take place directly between two
traders, or on unregulated exchanges or informal dealer networks.

Position Limits—In commodity markets, the maximum number of futures
contracts a trader or institution is allowed to hold for a given commodity.

—Tillman Clark and Ben Collins

Some observers have argued that index
investors themselves may have pushed
already-high prices of commodities even
higher. Hedge fund manager Michael Masters testified to the U.S. Senate that
the total holdings of commodity index
investors on regulated U.S. exchanges
have increased from $13 billion in 2003
to nearly $260 billion as of March 2008.
And as of April 2008, index investors
owned approximately 35% of all corn
futures contracts on regulated exchanges
in the United States, 42% of all soybean
contracts, and 64% of all wheat contracts,
compared to minimal holdings in
2001. As Masters emphasized, these are
immense commodity holdings. The wheat
contracts, for example, are good for the
delivery of 1.3 billion bushels of wheat,
equivalent to twice the United States' annual
wheat consumption.

Index fund managers have defended
against charges that commodity index
investment contributes to higher prices,
arguing that because index funds never
take delivery on their futures contracts,
they simulate commodity price shifts for
their investors without affecting the price
of the underlying commodity. Some economists
have also expressed skepticism
that investment demand has driven commodity
prices higher. Paul Krugman of
Princeton University has noted that there
is no evidence of "the usual telltale signs
of a speculative price boom" such as
physical hoarding of commodities. Furthermore,
Krugman and others have
pointed to non-exchange traded commodities
such as iron ore that have also
experienced rapid price increases during
recent years, arguing that fundamental
supply and demand factors, not investors,
are to blame for higher commodity
prices.

Other economists and commodity
market observers have argued that despite
price increases in non-exchange
traded commodities, and an absence of
physical hoarding, the recent flood of
money into commodity markets has altered
the balance between speculators
and hedgers, leading to higher prices and
greater price volatility. Mack Frankfurter,
a commodities trading advisor at Cervino
Capital Management, suggests that the
influx of commodity index investors has
transformed commodity futures from
tools for risk management to long-term
investments, "causing a self-perpetuating
feedback loop of ever higher prices."
One reason the precise impact of index
investors on commodity prices is difficult
to determine is that the U.S. commodity
trading regulator, the Commodity Futures
Trading Commission (CFTC), does not
collect data on so-called "over-the-counter"
commodity trading—that is, trading
on unregulated markets—even though
the agency estimated that 85% of commodity
index investment takes place on
these markets. Because Masters's data on
the holdings of commodity index investors
only include the 15% of index investor
contracts that are held on CFTC-regulated
exchanges, total commodity index
investor holdings may be much higher
than his estimates.

In testimony that warned of the influence
of these unregulated markets on
commodity prices, Michael Greenberger,
the former head of the CFTC's Division
of Trading and Markets, estimated that if
unregulated trading of energy and agricultural
commodities were eliminated,
the price of oil would drop by 25% to
50% "overnight." If Greenberger is correct,
the effect on food commodity prices
would likely be similar. However, index
investment is just one of many avenues
through which money can enter commodity
markets, making it difficult to assess
the impact of index investors without taking
into account the recent deregulation
of U.S. commodity markets that has facilitated
the current boom in food and
energy investments.

Commodity Trading
Regulation, Enron-Style

Commodity index investment is deeply
intertwined with the growth of unregulated
commodity trading authorized by
the Commodity Futures Modernization
Act of 2000. Before 2000, U.S. commodity
futures contracts were traded exclusively
on regulated exchanges under the
oversight of the CFTC. Traders were required
to disclose their holdings of each
commodity and adhere to strict position
limits, which set a maximum number of
futures contracts that an individual institution
could hold. These regulations were
intended to prevent market manipulation
by traders who might otherwise attempt
to build up concentrated holdings of futures
contracts in order to manipulate the
price of a commodity.

The 2000 law effectively deregulated
commodity trading in the United States
by exempting over-the-counter commodity
trading outside of regulated exchanges
from CFTC oversight. Soon after the bill
was passed, several unregulated commodity
exchanges opened for trading, allowing
investors, hedge funds, and investment
banks to trade commodities futures
contracts without any position limits, disclosure
requirements, or regulatory oversight.
Since then, unregulated over-thecounter
commodity trading has grown
exponentially. The total value of all over-the-
counter commodity contracts was
estimated to be $9 trillion at the end of
2007, or nearly twice the value of the
$4.78 trillion in commodity contracts
traded on regulated U.S. exchanges.
Once these unregulated commodity
markets were created, energy traders and
hedge funds began to use them to place
massive bets on commodity prices. Enron
famously exploited deregulated electricity
markets in 2001, when the firm managed
to generate unheard-of profits by using its
trading operations to effectively withhold
electricity and charge extortionate rates
from power grids in California and other
western states.

Although Enron went bankrupt later
that year, the hedge fund Amaranth later
exploited unregulated natural gas markets
prior to its 2006 collapse. The fund
had been heavily invested in complicated
bets on the price of natural gas, borrowing
eight times its assets to trade natural
gas futures, and lost $6.5 billion when
natural gas prices moved in the wrong
direction. One month prior to Amaranth's
collapse, the New York Mercantile Exchange
(NYMEX), which is regulated by
the CFTC, asked Amaranth to reduce its
huge natural gas position. Amaranth reduced
its position at NYMEX's request,
but purchased identical positions on the
unregulated InterContinental Exchange,
where its transactions were invisible to
regulators until the fund finally collapsed. Amaranth's implosion demonstrated
the ineffectiveness of regulating some
commodity exchanges but not others.
Thanks to the Commodity Futures Modernization
Act, traders could flout position
limits and disclosure rules with impunity,
simply by re-routing trades to
unregulated exchanges. Although index
investment in commodities does not typically
involve white-knuckle, leveraged
bets on a single commodity's short-term
performance, index investment was made
possible by the same deregulated environment
exploited by Amaranth and Enron.
Like Amaranth, commodity index investors
commonly purchase futures contracts
on unregulated markets when they exceed
CFTC position limits on futures contracts
for a particular commodity. And other
financial actors such as investment banks,
hedge funds, or even the sovereign wealth
funds of other countries may also be
heavily invested in these over-the-counter
commodity contracts, but since this trading
is unregulated and unreported, the
holders of these $9 trillion worth of contracts
remain anonymous.

This year, the CFTC has faced intense
scrutiny from investors, politicians, farmers,
and agricultural traders over the unprecedented
volatility and price increases
of several agricultural and energy commodities
traded on U.S. exchanges. A
lively CFTC roundtable on commodity
markets in April appeared to confirm arguments
made by Frankfurter, Greenberger,
Masters, and other critics of commodity
index investment. Representatives
for farmers, grain elevator operators, and
commercial bankers at the hearing repeatedly
stressed that commodity markets
were "broken," while the only pleas
for calm came from CFTC economists
and representatives for index investors
and the financial industry. Unlike index
investors, farmers have not benefited
greatly from higher commodity prices,
because extremely high levels of market
volatility have made it difficult for some
farmers to finance crop planting. National
Farmers Union president Tom Buis
sounded a particularly dire warning about
the consequences of tight commodity supplies
and burgeoning index investment
demand: "We've got a train wreck coming
in agriculture that's bigger than anything
else we've seen."

Following these warnings from farmers
and food producers about the presence
of index investors in commodity
markets, the CFTC's acting chair publicly
acknowledged the ongoing debate over
"whether the massive amount of money
coming into the markets is overwhelming
the system." Despite this admission,
Greenberger, the former CFTC official,
remains skeptical of the agency's capacity
and willingness to regulate commodity
markets effectively. He urged Congress
and the Federal Trade Commission to circumvent
the CFTC's authority and eliminate
unregulated over-the-counter commodity
trading. Recently, faced with
strong criticism from Congress, the CFTC
retreated further from its claim that commodity
markets are functioning normally.
A CFTC commissioner admitted: "We
didn't have the data that we needed to
make the statements that we made, and
the data we did have didn't support our
declarative statements. If we were so
right, why the heck are we doing a study
now?"

The Consequences of Financializing Food

Facing political pressure by constituents
over high oil and food prices, several
members of Congress have sponsored legislation
that would bar index investors
from commodity markets. One bill proposed
by Sen. Joseph Lieberman (Ind-
Conn.) would prohibit public and private
pension funds with more than $500 million
in assets from trading in commodity
futures, and other bills would limit the
maximum number of futures contracts an
index investor could hold. These bills
may stem the flood of money from index
investors into commodities, but comprehensive
reform is needed to reverse the
Commodity Futures Modernization Act's
authorization of over-the-counter commodity
trading. Absent an outright repeal
of this so-called "Enron loophole," energy
and agricultural commodities will
continue to be traded outside the reach of government regulation, making future
Enron- and Amaranth-style market disruptions
inevitable.

Ultimately, eliminating unregulated
commodity trading cannot address the
fundamental causes of higher agricultural
prices. Even if speculative buying is curtailed,
supply and demand factors such as
falling crop yields, destructive trade policies,
and the growing use of biofuels have
likely brought the age of cheap food to an
end. However, if the critics of commodity
index investment are correct, then these
investors have amplified recent food price
shocks and are needlessly contributing to
the impoverishment of the world's poorest
citizens. Even though commodity market
transparency and regulatory oversight
will not solve the global food crisis, eliminating
unregulated commodity trading can
help resolve the debate over the effects of
index investors on commodity prices and
restore the accountability of commodity
markets to the social interests they were
originally established to serve.

Ben Collins is a member of the Dollars & Sense
collective and a research analyst at KLD Research & Analytics, a sustainable investment research company. Mr. Collins's views do not necessarily reflect those of KLD or its clients.